AeroVironment, Inc. (AVAV) Q3 2016 Earnings Report, Transcript and Summary

Welcome to AeroVironment, Incorporated third quarter FY '16 earnings call. [Operator Instructions]. With us today from the Company is the Chairman and Chief Executive Officer, Mr. Tim Conver; President and Chief Operating Officer, Mr. Wahid Nawabi; Senior Vice President and Chief Financial Officer, Mr. Raymond Cook; and Vice President of Investor Relations, Mr. Steven Gitlin. And now at this time, I would like to turn the conference over to Mr. Gitlin. Please go ahead, sir.

Thank you, Bridget. Welcome to our third quarter FY '16 earnings call. Please note that on this call, certain information presented contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties, including but not limited to economic, competitive, governmental and technological factors outside of our control that may cause our business strategy or actual results to differ materially from the forward-looking statements. For a list and description of such risks and uncertainties, see the reports we file with the Securities and Exchange Commission. Investors are cautioned not to place undue reliance on any forward-looking statements, which speak only as of the date on which they are made. We do not intend and undertake no obligation to update any forward-looking statements whether as a result of new information, future events or otherwise. The content of this conference call contains time-sensitive information that is accurate only as of today, March 8, 2016. The Company undertakes no obligation to make any revision to the statements contained in our remarks or to update them to reflect events or circumstances occurring after this conference call. We will begin with remarks from Tim Conver. Tim?

Thank you Steve and welcome to our third quarter FY '16 conference call. Our FY '16 third quarter was in line with our expectations. Third quarter revenue of $67.6 million increased year-to-date revenue to $179.9 million and a favorable product mix kept third quarter gross margin strong at 39.4%. Taking a broad view of the quarter and the year, we think there are some key points to note from today's call. First, our core business of small UAS and EES remains strong and profitable, with leading market positions, growth opportunities and solid customer relationships. Second, we believe that the incremental investments in research and development and SG&A will position AeroVironment for growth opportunities, we expect to deliver long term value creation and significant ROI. And third, if we did not believe that these significant incremental investments would provide the highest ROI opportunity, we could reduce and eliminate or eliminate them for the corresponding increase in operating earnings that the core business is otherwise generating. On today's call, I will provide an overview of Q3 and year-to-date financial performance. Our President and COO Wahid Nawabi will review the Q3 highlights in our core business, which includes small UAS and EES as well as the substantial progress we are making across our growth portfolio. Our CFO Raymond Cook will follow Wahid with the review of Q3 and year-to-date financial performance, after which I will update our view on the remainder of FY '16. Year-to-date revenue increased by 4% and gross margin increased by 26% from FY '15 to FY '16. Third quarter UAS revenue increased $3 million year over year while company revenue and gross profit for the quarter were about 1% lower. Operating profit year to date has increased by more than 150% year over year. Year-to-date gross margin is growing faster than revenue, with some effects from mix and reserves. These year-to-date results do not reflect the high levels of research and development and marketing planned for Q4. We anticipate that high Q4 investments could still offset most or all of the operating profit or the full FY '16. Even though we are building inventory in anticipation of high Q4 deliveries and continuing to invest strategically in research and development opportunities, we are maintaining our operating management discipline as demonstrated by our Q3 free cash flow of $15.7 million. As we move to the fourth quarter, our primary focus continues to be supporting and anticipating the needs of our customers and executing effectively in our core businesses. At the same time, we remain committed to incremental investments to enhance stockholder value in the long term. These investments include development of a new growth opportunity in commercial UAS, a market expected to generate significant value across multiple large global industries. Commercial UAS represents a compelling new market opportunity where we believe our prudent and targeted investments can enable us to establish a strong position by being the first to develop and deliver the right system solution. With that, I will turn the call over to Wahid for his review of Q3 highlights in our core business and our growth portfolio. Wahid ?

Thanks Tim. Before I review the quarter's highlights, I would like to take a moment to express my enthusiasm in helping to fulfill the potential of this amazing organization as AeroVironment's President and COO. I'm most excited about the outstanding AeroVironment team and what we can achieve together. In my various roles at the Company from leading our EES business segment to establishing an integrated functional organization to working closely with our UAS team, I have enjoyed broad exposure to our people, customers and our solutions. Throughout my experience here, I have continually been impressed by the intelligence and passion of our teammates. We are in the business of developing and delivering innovative technology solutions that help our customers accomplish their missions whether on the battlefield or in the marketplace. I'm certain that our team will continue to work hard to create value for our customers and our stockholders. I look forward to spending more time with our stockholders and analysts, communicating our strategy and the exciting opportunities that lie ahead for AeroVironment. Now on to our Q3 highlights beginning with our EES business segment, our North America Level 2 charge dock deployment footprint for on-boat electric vehicles which s auto dealerships, residences and other businesses surpassed 31,000 units at the end of third quarter. That number includes more than 200 of our new TurboDock system, which are designed for access control workplace charging and for which demand appears to be growing. In industrial electric vehicle charging systems, early in Q4, we introduced our new PosiCharge ProCore, a premium intelligent family of scalable charging systems. We believe PosiCharge ProCore, the first smartphone configurable charger for industrial EVs, will help us to further our penetration of the industrial charging market and increase EES revenue in coming years. This is another indication of our ongoing market leadership and commitment to developing innovative solutions that allow our customers to move forward with confidence while also expanding the adoption of electric vehicles. Now let's look at our UAS business, which continued its solid performance in the quarter with revenue of $61 million in the third quarter, an increase of 5% over the prior year. AeroVironment benefits from the leading market position for small UAS and defense applications, with the largest share within the U.S. Department of Defense and a growing international footprint. In third quarter, we received a $13 million Puma all environment order from the U.S. Marine Corps, which demonstrates the important role that our small UAS continue to play in keeping troops safe and helping them become even more effective. Similarly, our track record of winning more than 90% of the task order revenue year-to-date from the U.S. Army small UAS IDIQ contract competing against four other companies supports our leading position in this key market. Our customer base continues to grow internationally and we see strong adoption signals from maritime customers based on our all environment and autonomous landing Puma AE systems. Puma AE systems can operate for nearly four hours per flight and land themselves into portable nets that do not require modifying ship decks, an important capability for maritime adoption and a competitive advantage for our company. They also provide organic ISR for critical missions from ships of all sizes and purposes. In December, we deployed an AeroVironment crew with a Puma AE system onboard the U.S. Coast Guard icebreaker Polar Star. During its Antarctic mission as part of Operation Deep Freeze, our Puma AE system flew more than 25 miles from the ship in the harsh Antarctic environment on one of its multiple scouting flights. This is a great example of the professional differentiation of our small UAS from consumer and most commercial drones that can only operate in ideal weather conditions. This year, we continue to make significant progress positioning ourselves to grow into the maritime small UAS market and Puma AE's capabilities supported maritime operations with demonstrations, new orders and greater interest in this unique capability. We are confident that these competitive advantages will contribute to our growth. The international market for small UAS has demonstrated strong potential this year. Fiscal year to date, AeroVironment added four new ally customers to the more than 30 allies who have procured our small UAS solutions and three of these new customers took initial delivery in the third quarter. Third quarter international small UAS revenue increased by more than 80% year over year, with foreign military sales accounting for 50% of that revenue and direct commercial sales constituting the balance. Our growth portfolio progressed further towards realizing its value creation potential with tactical missile systems, commercial UAS and large UAS. In tactical missile systems or TMS, our incremental R&D investment in Switchblade variants during FY '15 supported customer adoption in FY '16. In the same way we develop Switchblade and all of our solutions with our own initial investment followed by customer funding, demonstration and then growing adoption, we are moving the four identified Switchblade variants through our innovation process with positive results. We're building a family of tactical missile systems optimized for multiple customer applications with unique advantages that are common across this product family. These advantages result from AeroVironment's strong innovation and knowledge of the customer's mission and position us well to support long term business growth. For the first time, the president's proposed budget, which was released in February, included a line item request for lethal miniature aerial missile systems also known as LMAMS. This is a significant customer development that potentially supports greater tactical missile systems visibility through a defined budget line item with associated documentation and multi-year customer procurement planning. This is also a positive indicator of the U.S. Army's favorable experience with AeroVironment Switchblade system that bodes well for the Army's longer term adoption of LMAMS. There is a broad set of opportunities for our tactical missile systems and we're making significant progress towards realizing them. Shifting now to the growth opportunity in our large UAS business, we continue to focus on business development activities to introduce atmospheric satellites that can provide greater capability and lower cost to government and commercial customers across the globe. With this initiative in its early stages, we continue our optimistic dialogue with interested parties. In commercial UAS, we're dedicated to gaining greater insight into our customers' needs from our direct engagement and primary research. As such, we continue to invest in developing the software, hardware and payloads that will provide a seamless solution that customers can use to understand better and thereby manage their operations more effectively. Our next phase of projects with the early adopters is designed to validate our solution and business case further and will continue to inform our market introduction plans to maximize customer ROI, our market share and value creation. We are engaged with customers in agriculture, energy, transportation and power industries. These are emerging commercial markets represent large opportunities for us. We believe we are developing the customer relationships, integrated solutions and business models to position us for market leadership and growth. With this overview of the quarter, Raymond Cook will now provide a more detailed review of our financial performance, after which Tim will return for his thoughts about the balance of the fiscal year.

Thank you Wahid and good afternoon everyone. AeroVironment's FY '16 third quarter results are as follows. Revenue for Q3 was $67.6 million, a decrease of $0.8 million or 1% as compared to $68.4 million a year ago. The decrease in revenue was due to a decrease in product deliveries of $3 million, partially offset by an increase in service revenue of $2.2 million. Looking at revenue by segment, UAS revenue was $61.6 million, an increase of $3.1 million or 5% compared to last year. The increase was primarily due to an increase in service revenue of $1.3 million and an increase in customer funded R&D work of $0.9 million and an increase in product deliveries of $0.9 million. EES revenue decreased $3.9 million or 38% to $6.5 million in the third quarter. The decrease was primarily due to a decrease in product deliveries over industrial fast charge systems and product delivery from our passenger electric vehicle charging systems. Turning to gross margins, gross margin for the third quarter was $26.6 million or 39%, a decrease of $0.4 million as compared to $27 million or 39% in the prior year. The decrease in gross margin was due to a decrease in product margins of $2 million, largely offset by an increase in service revenue margins of $1.6 million. By segment, UAS gross margin decreased to $24.6 million for the three months ended January 30, 2016 from $24.8 million. As a percentage of revenue, gross margin for UAS decreased from 43% to 40%, primarily due to product mix. EES gross margin decreased $0.2 million or 9% to $2 million in the quarter, primarily due to decreased sales volume. As a percentage of revenue, EES gross margin increased from 21% to 31%, primarily due to product mix. SG&A expense for the third quarter was $13.3 million or 20% of revenue compared to SG&A expense of $13.3 million or 19% of revenue in the prior year. R&D expense for the third quarter was $8.2 million or 12% of revenue compared to R&D expense of $8.6 million or 13% of revenue in the prior year. The operating income for the third quarter was $5.1 million or 7% of revenue compared to operating income of $5.1 million or 8% of revenue in the prior year. The benefit for income taxes for the quarter was $1.1 million for an effective tax rate of negative 22.5% compared to the provision for income taxes of $2.8 million or an effective tax rate of 54.3% in the prior year. The tax benefit was primarily due to legislation reinstating the federal research and development tax credits during the current order. The net income for the quarter was $6.2 million or $0.27 per diluted share compared to net income of $2.3 million or $0.10 per diluted share in the same quarter last year. Now moving through our first nine months of FY '16 results, revenue for the first nine months of FY '16 was $179.3 million, an increase of $6.4 million or 4% as compared to $172.9 million a year ago. The increase in revenue was due to an increase in service revenue of $19 million partially offset by a decrease in product delivery of $12.6 million. UAS revenue was $157.8 million, an increase of $15.6 million or 11% compared to last year. The increase was primarily due to an increase in customer funded R&D work of $17.7 million and an increase in service revenue of $1.8 million partially offset by a decrease in product deliveries of $4 million. The increase in customer funded R&D work was primarily due to an increase in development programs related to tactical missile systems and large UAS. EES revenue decreased $9.2 million or 30% to $21.5 million for the nine months ended. This decrease was primarily due to a decrease in product deliveries of our industrial fast charge systems and in product deliveries of our passenger electric vehicle charging systems. Gross margin for the first nine months was $74.2 million or 41%, an increase of $15.3 million as compared to $58.9 million or 34% in the prior year. The increase in gross margin was primarily due to an increase in product margins of $5.4 million and an increase in service revenue margins of $9.8 million, both of which were impacted by the government contract reserve reduction recorded in the second quarter on the settlement of prior-year incurred cost audits. UAS gross margin increased $16.2 million or 32% to $66.6 million for the nine months ended January 30, 2016. The increase was primarily due to an increase in margins on product sales and service related contracts and the government contract reserve reduction. As a percentage of revenue, gross margin for UAS increased from 35% to 42%. EES gross margin decreased $0.9 million or 11% to $7.6 million for the first nine months of FY '16, primarily due to lower sales volume. As a percentage of revenue, EES gross margin increased from 28% to 35%, primarily due to product mix as the government contract reserve reduction. SG&A expense for the first nine months was $43.3 million or 24% of revenue compared to SG&A expense of $40.1 million or 23% of revenue in the prior year. SG&A expense increased $3.2 million primarily due to higher bid and proposal costs. R&D expense for the first nine months was $28 million or 16% of revenue compared to R&D expense of $24.2 million or 14% of revenue in the prior year. The operating income for the first nine months was $2.9 million or 2% of revenue compared to prior-year loss of $5.5 million or 3% of revenue. The increase in operating income was primarily due to higher gross margins of $15.3 million offset by an increase in R&D expense of $3.7 million and an SG&A expense of $3.2 million. Net other expense for the first nine months was $2.1 million compared to prior year net other income of $0.4 million. Net other income decreased primarily due to the first half of FY '16 other than temporary impairment loss on our CybAero equity securities of $2.2 million. The effective income tax rate benefit for the first nine months was a negative 361.2% compared to the effective tax rate benefit from prior year of a negative 18%. The net income for the first nine months of FY '16 was $3.6 million or $0.16 per share compared to a net loss of $4.2 million or an $0.18 loss per share in the first nine months of last year. The diluted earnings per share for the first nine months of FY '16 increased by $0.09 due to the reserve reversal on settlement of incurred cost claims, which was partially offset by $0.06 due to losses on impairment and sale of CybAero equity securities. Looking at backlog, funded backlog at the end of the third quarter was $79.7 million, a decrease of $17 million or 18% from the end of the second quarter of $97 million. Turning to our balance sheet, cash, cash equivalents and investments at the end of the third quarter totaled $258.6 million, an increase of $14.9 million from the prior quarter. The increase in cash, cash equivalents and investments was driven by the net income and lower working capital used in the business. Turning to receivables, at the end of the third quarter, our accounts receivable including unbilled and retention receivables totaled $49.4 million, a decrease of $5.1 million from the prior quarter. Total days sales outstanding was approximately 66 days compared to 76 days at the end of the prior quarter. Taking a look at inventory, net inventory was $46.4 million at the end of the quarter compared to $48.3 million at the end of the prior quarter. Days in inventory were approximately 102 days compared to 131 days at the end of the prior quarter. The decrease in days in inventory was primarily attributable to the increase in third quarter shipments. Turning to capital expenditures, in the third quarter we invested approximately $1.5 million or 2% of revenue in property improvements and capital equipment. AV recognized $1.8 million of depreciation and amortization in the quarter. Now I would like to talk about our Q3 out of period adjustments and material weakness. During the quarter ended January 30, 2016, we identified and corrected errors related to our state used tax liability and certain capital lease agreements previously misclassified as operating leases. These errors were assessed and concluded not to be material to the consolidated financial statements taken as a whole. As a result, the current quarter includes approximately $0.8 million of expense related to prior fiscal years. We assessed the impact of our internal control environment and determined that we have a material weakness in internal control over financial reporting with respect to our state use tax process. We have implemented appropriate controls to remediate the material weakness, which will be tested during our fourth fiscal quarter of 2016. We expect the remediation of this material weakness may be completed as early as April 30, 2016. Now I would like to turn things back to Tim to discuss AV's expectations for the remainder of FY '16.

Thank you, Raymond. Our solutions address existing and emerging needs across both defense and commercial markets. In our core business, we maintain strong market leadership in small UAS and EES, with about 88% of our year-to-date revenue generated from solutions we delivered to defense customers. Within the defense market, we are also focused on expanding our customer base for small UAS and for tactical missile systems Switchblade variants. Ongoing defense customer R&D funding of our tactical missile systems illustrates the value they place on this growing family of munitions systems for their urgent and their future needs. Commercial UAS and operating atmospheric satellites represent very large growth opportunities in new markets. Our current investments to develop and pursue new growth opportunities are primarily on the income statement in the form of R&D and SG&A rather than on the balance sheet. To help frame the potential the commercial UAS opportunity, a study conducted by AUVSI projected unmanned airplane systems solutions for the U.S. agriculture market alone could generate incremental economic value of billions of dollars over 10 years. As we look to the balance of the fiscal year, we expect quarterly revenue to be the highest of the year in our fourth quarter. Our original guidance range for full-year 2016 revenue of $260 million to $280 million is unchanged. However, we still need to received contracts for some shipments planned for Q4 revenue and a significant percentage of our anticipated Q4 revenue consists of international deliveries which inherently have a greater timing uncertainty due in part to export license requirements. As a result, we now expect our full FY '16 revenue to be in the lower half of our guidance range. Gross profit has trended higher year to date. Even though we continue to expect lower gross profit margin in the fourth quarter, full-year gross profit percentage is now expected to be higher than we planned at the beginning of the year and we are raising our gross profit margin guidance for FY '16. Our new guidance range is 38% to 39.5%. We expect to increase research and development in SG&A spending significantly in Q4 as I previously discussed. Some of this Q4 increase was by plan and some was caused by earlier schedule delays. We plan to nearly double R&D investments from Q3 to Q4. We also plan to significantly increase business development and marketing investments. These investments in R&D and SG&A could likely offset most or all of the operating profit we would have otherwise reported for FY '16, consistent with our guidance from the beginning of the year. Thank you to the AeroVironment team members whose commitment to turning great ideas into innovative technology solutions enables our customers to move forward with confidence. As always, we appreciate the ongoing interest in AeroVironment from each of you and now Raymond, Wahid and I will take your questions.

[Operator Instructions]. Our first question is from Bobby Burleson with Canaccord. Your line is open.

So I guess just high level for Tim. There's been obviously some headwinds in terms of capital budgets for energy companies and I'm wondering even though you are probably a couple of layers removed from those kind of headwinds I'm wondering whether or not you are seeing any kind of impact on a level of customer engagement activity for commercial UAS in that particular vertical or any kind of impact whatsoever?

Well as you know we began our commercial operations with small UAS in the Arctic because that was the first area that the FAA approved when they initially gave us limited certification for commercial operation of Puma and subsequently we engaged heavily with BP in their Arctic operations and through that engagement demonstrated significant economic benefits that BP reported across multiple applications in that rigorous environment and with the rigorous safety requirements that they and other elements players in the oil patch require. And since that time and this time as we are all aware the price of oil has plummeted and there have been significant impacts in the industry. In the meantime we have engaged much more broadly with the advent of greater latitude from the FAA much more broadly and other industries as Wahid mentioned including power generation, transportation, agriculture and others and within those other industries we are engaged with multiple lead adopter customers and while we continue to have an active interest in and see significant benefits in the oil and gas industry it may be that earlier material adoption will occur in other industries given the macroeconomics going on right now that you referred to.

And I'm just wondering this is obviously a year for some strategic investment that you are making, impacting your operating income and I'm wondering is this something that’s sustainable or necessarily sustained into 2017 or are we kind of winding down in terms of levels of investment where maybe you guys can slow this spending a little bit next year?

The incremental investments that we began making in commercial UAS solution development last fiscal year have continued this fiscal year and in both cases we have indicated when we began the year that we expected the total incremental investments we are developing and those growth opportunities could offset the operating profits that we would otherwise be generating. We have not yet provided any guidance for FY '17 and our expectation is as we usually do we would provide that guidance on our Q4 call at the end of Q4 for 2016. So I think we have adequately addressed hopefully the expectation for this year. I think we will not expect there to be a cliff at the end of this fiscal year and we are finished with the development of commercial UAS completely. However you may recall that last fiscal year we were incrementally investing above our historic levels of 8% to 10% of R&D to address three different growth opportunities where we had immediate customer signals in looking like they were doing the kinds of things they would be doing that if they were getting ready to adopt and that addressed large UAS opportunities, tactical missile systems and commercial UAS. And at the conclusion of FY '15 we accomplished our objectives in large UAS incremental investment and in the incremental investment in tactical missile systems so as we enter this fiscal year those growth opportunities in addition to our core businesses were all being planned to be addressed within our historical 8% to 10% of R&D. And the incremental investments this year were exclusively associated with developing commercial UAS. So we do have a pattern of tightly managing those incremental investments, getting the work done and then returning to business as usual. And I think Wahid also focused in his comments about the benefits and the returns that we are seeing already this year in tactical missile systems and the adoption of multiple variants as a result of those FY '15 investments.

And your next question is from Howard Rubel with Jefferies. Your line is open.

First to talk about efficient energy systems for a minute, Tim it's sort of been in this $6 million to $8 million range for some time. Do you see any reason why that would accelerate or embark on any other path?

Let me see if I could try to shed some light to your question. Yes the EES business as you saw the revenue has been down year-over-year and that's actually primarily based on two things. Primarily based on lower shipments of our industrial electric vehicles as well as the focus of our strategy to narrowing it down to specific plays and strategies and business models that we think is going to have a long term play for us and a long term ROI. And we explained that in the last quarter if I'm not mistaken in terms of the product line primarily being around the TurboCord platform of technology that essentially feeds all of our AC charging infrastructure products for EV Solutions. So we've narrowed our focus over the years and initially we experimented these different business models very frugally to see which business model and what type of application and what type of adoption is going to have a viable long term play for us. And so now since we learned from those experiments and we have learned from our product deployments that the strategy we have are on TurboCord is the right strategy to move forward we have narrowed that focus and we're executing that strategy today.

Just to follow up on that it's clear the profitability as much better with a little more consistency so I think that's one of the fruits of this labor I suppose?

That is accurate. One of the benefits of focusing on a -- what I refer to as one platform based on the TurboCord technology enables us A, to have one development cycle that could benefit multiple products for multiple application at the same time it helps our cost structure in terms of volume that we make the same platform for multiple products and eventually it will actually be a global platform that we can deploy globally as we move forward in this market.

If I just made just to talk about LMAMS for a moment, it looks as if you have the camel's nose under the tent. I saw about $4.5 million I think in the President's budget for that but there is typically a lot more than that behind that. Could you either you or Tim provide a little bit of color and context please?

Sure. So let me try if I could add some color to that. The line item budget that as you just mentioned certainly as I mentioned in my earlier remarks is a positive indicator of our government realizing and getting more serious about LMAMS as a program of record. Although the process and the steps towards that outcome still is quite long and not very clear as to when and how that's going to happen within the DoD budgeting process. Obviously there's a process that DoD has, the steps that they go through but the timing of course is very difficult to predict. Having said that we continue to see very strong interest from our customers in the Switchblade family of products and since the inception of Switchblade we now have four additional variants of that product in various stages of adoption. We typically start that cycle with the concept development based on our own R& D and once the customer gets to see the value in the capability of these innovations then we see the customers actually providing funding towards further development and then eventually we get into an initial production and long term adoption. So we're in different phases of that cycle with various variants of this product and we expect this product line to do well and we expect our customers to benefit from the unique advantages and capabilities that this product line offers to our military.

Our next question is from Peter Arment with Sterne, Agee. Your line is open.

Tim, question on the Puma order that you mentioned $13 million received from the Marine Corps. I think the last thing I had seen from them that they indicated they were looking for an objective of something like 87 systems. Where does this order fit into that? Should we expect more on the backside of that throughout the year maybe you could just start there?

We think this is just a continuation of their commitment to their next-generation family of systems requirement that they established last year that has Puma on the large side and WASP [ph] on the small side of their small UAS platforms and that brackets the prior ravens system that they had previously procured. So I think it's another step forward as they apply their scarce financial resources to filling out that objective requirement.

And then just regarding the adoption of Puma you kind of hinted at some of the further interest that has grown from the Navy and the Coast Guard what should we expect on the development there?

So Peter on the Puma A system we believe that our products in that system offer a substantial benefit and competitive advantage to our customer base and to our military and various international customers as well. We're in of various stages of adoption of that system in that product category with various customers both domestically and internationally and so we've been working with the U.S. Navy for a long time on the maritime application of Puma AE and so far the indications are fairly positive and the fact that we are now able to deploy Puma AE systems without any modifications to any type of ship that's within the Naval footprint is what I consider a significant progress towards enabling adoption to occur. When and how that materializes itself as we mentioned before it's hard to predict in terms of exact timing but the indications are fairly strong and we are in constant engagement with our customers to help them get the benefit of these products and adopt the systems further within their footprint.

And our next question is from Troy Jensen with PHC. Your line is open.

Maybe for Tim quickly, I guess it [indiscernible] your confidence or conviction that we're going to see growth in U.S. military drone spending in 2016 so stripping out international expansion do you think U.S. drone market will grow for you this year over last year?

Okay Troy, if I understood your question it was primarily around if you were to take out the defense use of our products domestically and not internationally where do we see the growth is that accurate?

Yes domestic spending, yes

So Troy with our family UAS [ph] systems we are as you know we have shipped a large number of systems already to the U.S. Army for many years and since the initial deployment of those systems we have gone through various engagements of various other branches of the military namely the Navy the U.S. Coast Guard and special operations and of course there are others one too. In each case the development cycle or the adoption cycle that we are engage with those customers vary and so while the U.S. Army you could argue may not have such a huge demand for these products for the short term basis other branches of the military will and so as a whole we are quite positive on the strength of our core business domestically and on top of that we have a growing number of international customers as you heard earlier and there seems to be strong interest from multiple international customers across the entire family of our small UAS systems.

Okay. I understand and my follow-up question will be on your commercial market focused here. Just curious to know if you're going to pursue the same strategy you did BP, where you're planning to getting a tight certification for your new drone platform and can you speak to what the competitive advantages would be to have a tight certification from competitors?

The point you are making I think is we are uniquely have a tight certification on Puma and we are using Puma primarily although not exclusively in the pilot programs that we are engaged with multiple customers in multiple industries now. At the same time the next generation solution for commercial applications that we are developing incorporates the development of software payloads and platforms that are optimized for those commercial applications and it may or may not turn out to be a critical differentiator to pursue tight certification on the platform itself at that time and I think we are cognizant of the opportunity and will make that decision as we get close to deployment and evaluate how the FAA's process of approving commercial operations evolves over time and as you know that is evolving rapidly.

[Operator Instructions]. Our next question is from Josephine Millward with Benchmark Company. Your line is open.

Can you give us an update on your visibility to guidance whether to the low end or the mid end and do you still expect EES to be flat for the year because that was your assumption in the past?

So I will just walk you through our updated FY '16 visibility. So as of today we have year-to-date Q3 revenues of $179 million. Our Q3 ending backlog that we expect to execute in FY '16 is an additional $66 million. Our Q4 quarter to-date bookings that we anticipate to execute in FY '16 is an additional $4 million and our unfunded backlog from incrementally funded contracts that we anticipate to recognize revenue during the balance of the year is $0.4 million. So this adds up to $250 million or 93% is the mid-point of our revenue guidance of $260 million to $280 million. And in our visibility walk down we typically include an assumption of revenue required for EES to be flat compared to the previous year. You will notice that we do not include that assumption in this walk down. The reason for the change this quarter is that EES year-to-date revenue is trending down compared to last year and we believe that full-year EES revenue will be lower than this year than last year. As a result we do not believe including that assumption would be helpful this quarter.

And looking ahead the overall defense budget is improving and looking at FY '17 budget do you think visibility is improving for AE in the coming year and can you talk about whether you expect commercial to be a driver for you in FY '17?

So in terms of the FY '17 budget for defense I'm personally not very versed into that budget but we believe that in general the prospects for small UAS and TMS family of systems which is part of our portfolio seems quite positive. We're in various customer engagements that show fairly strong signs of adoption and on our installed base we also have opportunities for upgrades and sustainment of our existing install base of 20,000 plus systems that are up there. And so from that perspective I think that the defense budget although it's far large and our portion of that is quite insignificant we typically on any given year see quite different types of demands based on urgent needs, based on upgrades, based on the needs of different forces within the military. So I just don't think that there is a very direct correlation between the total budget NAV but in general our space seems to be quite encouraging within the domestic markets for defense. And in regards to your commercial market as you’ve heard earlier commercial UAS revenues are not material to our total revenue this year and we're still in the early stages and we are engaged in various pilot project said you heard earlier from Tim and my remarks and it's a fairly large opportunity for the long run and at this stage we're still formulating our business models and validating the customers' requirements and needs and a unique solution set that could really address their needs while delivering value to both our customers and our stockholders.

And our next question is from Joe De Nardi with Stifel. Your line is open.

This is [indiscernible] for Joe De Nardi. What's driving the increase investment in 4Q specifically? Is it customer competitions or bid activity and when do you expect to hear decisions on some of these opportunities?

I think -- if I heard your question right it's the increase in the investments in Q4 and what's driving that?

Yes.

It's two areas, research and development and business development/marketing and it's primarily around the incremental investments in commercial UAS that we are pursuing this year. Some of that was part of our initial plan that built those investments throughout the year and to the highest level in Q4 and then that is exacerbated by some schedule slides in those development programs that are now being picked up in Q4 and as a result as I mentioned in my comments our current expectation is that our Q4 R& D in total will almost double from our Q3 R&D and at the same time we are increasing business development and marketing investments that fall under SG&A.

And then at LMAMS, how did the funding broken out in the budget compared to what you were expecting and what are you hearing from the customers how this ramps up and what's the expectation for when it gets included in the base budget?

Well last year you may recall that we were anticipating the possible introduction of LMAMS as in the palm which would have put the program on track for a potential program of record launch in government FY '17 I believe. It did not make the cut. As best as I can understand that went down to the wire but I'm not on the inside of those decisions. We are really pleased to see that it made it to a line item this year and we think that’s much more significant than the actual amount of money initially funded in that line item. So we hope to see hope, I take that word back, we believe we may see an ongoing acceleration of that and we certainly find that more of these systems are being used the greater the demand for these systems appears to be growing and we have seen and reported in our earlier discussions that we are receiving incremental funding for not only variant production solutions but customer funded research and development for additional variants. So I guess I will just end it with a general sense of optimism that these systems are doing the job that we had hoped they would for our customers and we are seeing the result in demand.

Now I'm not showing any further questions. So now I will turn the call back over to Mr. Gitlin for closing remarks.

Thank you, Bridget and thank you all for your attention today and for your interest in AeroVironment. An archived version of this call, all SEC filings and relevant company and industry news can be found on our website at avinc.com. We look forward to speaking with you again following next quarter's results. Have a good day.